Inequality did not cause the crisis

The notion that high inequality caused the economic and financial crisis that emerged in America in 2007-8 has become widely accepted. This claim should not be confused with the argument that an unequal society is morally or political undesirable. Instead it holds that according to objective economics the downturn was itself the result of excessive inequality.

This preoccupation with inequality is not confined to those associated with the egalitarian left. On the contrary, many mainstream politicians and economists, including some high-profile ones, are pushing it hard. US President Barack Obama has himself gone a long way down this road.

In some cases, leading free-market figures, usually associated with the political right, have also accepted all or part of the argument. Raghuram Rajan, the chief economic adviser to the Indian government and a professor at the University of Chicago, was one of the first to blame excessive inequality for the crisis.

The pro-market Economist magazine, although not going as far as Rajan, has argued for a ‘true progressivism’ where ‘the priority should be a Rooseveltian attack on monopolies and vested interests’. Its reference is to Theodore Roosevelt, the American president from 1901-9, who was an avid ‘trust buster’: a supporter of the break-up of corporations when it was deemed they had become too large.

This essay will examine the claim that high inequality is to blame for the crisis. It will consider whether inequality played a direct role or whether the impact was indirect. In addition, it will outline the political consequences of such arguments as well as outlining an explanatory alternative.

The account will focus on America as it is widely regarded as the place where the global crisis began. It also remains the largest economy in the world by a substantial margin. However, similar claims have been made on the damaging economic impact of inequality in Britain (see ‘Inequality a symptom not a cause’, Fund Strategy, 28 May 2012).

Widening inequality

It is almost universally accepted across the political spectrum that inequality in America has widened substantially in recent decades. For instance, a 2011 study by the Organisation for Economic Cooperation and Development (OECD), Divided We Stand: Why Inequality Keeps Rising, noted that inequality in America started to increase in the late 1970s and has continued to widen since.

There are numerous ways in which inequality can be measured, but in recent years there has been a particular focus on what is sometimes called ‘top inequality’. In more colloquial terms, this means focusing on, say, the growing wealth of the top one per cent, or even the top 0.1 per cent, rather than merely the richest 10 per cent.

Two French economists have pioneered the collection of data on top incomes: Emmanuel Saez of the University of California, Berkeley and Thomas Piketty of the Paris School of Economics. Their data on many countries is freely available to examine and download on the World Top Incomes Database.

This broad acceptance that inequality has widened since the 1970s still leaves much open for debate. For instance, there are disagreements on the extent to which average incomes in America have foundered over the same period (see ‘Average incomes “did not stagnate”’, Fund Strategy, 30 April 2012).

There is also ample room for debate about the cause of this widening of inequality. Globalisation and the increasing importance of education are two of the most popular reasons given, but there are alternative explanations.

The focus in this article is on whether inequality itself caused the crisis. In this respect, Paul Krugman, a Nobel prizewinner in economics and a New York Times columnist, made some useful distinctions in a 2010 talk on how the crisis can be understood. He outlined three broad possibilities:

* It could simply be a coincidence that inequality rose sharply for many years preceding the crisis.

* There could be actual causation. High inequality could somehow create economic vulnerabilities.

* There could be what he called ‘common causation’. In other words both widening inequality and the crisis could be caused by a common factor. For Krugman, neoliberal ideology, or what is often called free market economics, could be responsible for both.

The claim that widening inequality and the emergence of the economic crisis are a coincidence is not the subject of this piece. There are clearly other explanations for the crisis that need not involve inequality. For instance, it has been explained in relation to the misdeeds of the financial sector and with reference to global economic imbalances (‘A balancing act’, Fund Strategy, 17 August 2009).

However, it is worth noting at this point that it is possible to combine these alternative explanations with the inequality argument. Most obviously, the swelling of the banking sector in the run-up to 2008 is clearly compatible with growing wealth among those who worked on Wall Street.

Direct cause: demand gap

The most straightforward explanation for the link between inequality and the crisis is what could be called the demand gap. There are many variations of this idea, but at its core is the argument that most Americans, suffering from stagnating incomes, could not afford to buy everything they needed. This shortfall in consumption hit corporations, as their markets were limited, and ultimately the economy as a whole.

Most of the increase in wealth in society was, according to this view, going to those at the very top. America, it is argued, is increasingly becoming a winner-takes-all society rather than a market democracy. Yet there is a limit to how much the super-rich can consume. There are only so many yachts they can sail in, or private jets with which they can fly around the world. For this reason the economic oligarchs of ‘Richistan’ tend to save a high proportion of their money rather than spend it all.

The next stage in the argument is typically that the financial bubble emerged in response to the lack of overall demand. Financial institutions were encouraged to lend more by the authorities as the alternative was economic lethargy. Although this approach worked well in the short term, over the longer term it led to the inflation of a financial bubble and subsequent bust.

This kind of explanation was at least hinted at in an important speech given by Barack Obama in Osawatomie, Kansas, in December 2011. The president referred to inequality six times including in the following passage:

‘Now, this kind of inequality – a level that we haven’t seen since the Great Depression – hurts us all. When middle-class families can no longer afford to buy the goods and services that businesses are selling, when people are slipping out of the middle class, it drags down the entire economy from top to bottom. America was built on the idea of broad-based prosperity, of strong consumers all across the country. That’s why a CEO [chief executive officer] like Henry Ford made it his mission to pay his workers enough so that they could buy the cars he made. It’s also why a recent study showed that countries with less inequality tend to have stronger and steadier economic growth over the long run.’

Osawatomie was deliberately chosen as the venue for the speech for its symbolism. It was where Theodore Roosevelt, a Republican, gave an important speech in 1910 on what he called the ‘new nationalism’. In it, he advocated both equality of opportunity for citizens and greater government control over large corporations:

‘The true friend of property, the true conservative, is he who insists that property shall be the servant and not the master of the commonwealth; who insists that the creature of man’s making shall be the servant and not the master of the man who made it. The citizens of the United States must effectively control the mighty commercial forces which they have called into being.’

Obama was, at least by implication, endorsing a similar ‘true conservative’ initiative. In his view, today’s super-rich ‘robber barons’, the beneficiaries of a new Gilded Age, also need to be contained.

Robert Reich, who has acted as an adviser to Obama and was secretary of labour under Bill Clinton, has promoted a more explicit version of the inequality thesis. In his 2012 book Beyond Outrage, which is dedicated ‘to the Occupiers’, he blames the lack of purchasing power for the anemic recovery. ‘Because so much income and wealth have gone to the top, America’s vast middle class no longer has the purchasing power to keep the economy going – not, at least, without getting deeper and deeper into debt.’

This argument follows a claim that all the economic gains from the previous three decades had gone to the wealthy. Reich overtly argues that America has returned to a Gilded Age in which the US economy is dominated by a new oligarchy of plutocrats.

But it was Rajan, also a former chief economist at the International Monetary Fund, who first gave a high profile to the inequality argument. His Fault Lines won the Financial Times and Goldman Sachs Business Book of the Year Award for 2010 (reviewed in ‘Faulty project fails to reach core’, Fund Strategy, 17 January 2011).

The main driver of inequality in Rajan’s telling is rapid technological change. This in turn created a situation which the best educated could exploit to their financial advantage. The incomes of the rest of society fell behind as a result.

For Rajan, technological change and educational inadequacies provide the backdrop to what has become a familiar story. In response to this growing inequality, the American authorities create an artificial credit boom. For instance, the housing market was deregulated to make it easier for those on low incomes to borrow. Such measures helped create the housing boom that later turned to bust.

This story of crisis as the result of underconsumption would be familiar to earlier generations of economists. For instance, it was an important stream of thinking during the Great Depression of the 1930s. Back then, many economists argued that the underlying problem was the lack of consumption by the mass of the population. From this perspective it followed that economic stimulus should play a key role in any economic solution.

Indirect cause: rent-seeking

However, many contemporary accounts of inequality and the crisis add an additional twist to the argument. Typically they accept that underconsumption is a key problem but argue additional factors must be taken into account.

Although there are variations in the arguments, they generally focus on how the super-rich have allegedly corrupted the political process to enrich themselves further. The basic idea is that plutocrats have increasingly engaged in what economists confusingly call ‘rent-seeking’: rather than creating new wealth the new oligarchs have concentrated on manipulating politics to help them gain control over existing prosperity. In the jargon, they are extracting economic rent from the rest of society.

Although this notion can sound radical, even Marxist, it has its roots in free-market economics. The original concern was how to stop companies gaining an unfair competitive advantage by finding favour with the authorities. Contemporary critics of inequality, in contrast, are more concerned with using the notion of rent-seeking to legitimise state intervention.

Often, the theory of rent-seeking is accompanied by the idea of regulatory capture. In other words, powerful business interests have come to control the state institutions that are meant to regulate them.

The public debate often focuses on how Wall Street leaches off the rest of society and corrupts the political process. One well-known commentator even described Goldman Sachs, one of the leading investment banks, as a ‘a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money’. Apparently he was unaware of the anti-Semitic antecedence of such imagery. It is also commonly argued that financial interests have come to dominate regulatory institutions, such as the Securities and Exchange Commission.

This form of political manipulation by plutocrats is often portrayed as a key component of the economic crisis. It is typically seen as an underlying factor in widening inequality, and in the creation of a bloated financial sector.

This in essence is what Paul Krugman means by common causation. Inequality and the crisis have common roots. In his telling, the dominance of free-market or ‘neoliberal’ ideology led to both widening inequality and the economic crisis.

Krugman sees neoliberalism as the self-serving outlook of the plutocratic elite. It has come to dominate American political life through what he calls ‘movement conservatism’: hard-right Republican politicians along with associated think tanks, media outlets (such as Fox News) and publishing houses.

In his most recent book, End This Depression Now!, Krugman focuses on how the financial system persisted with deregulation despite it being ‘a recipe for trouble’. This happened at the same time as the very rich were making a lot of money from unregulated finance. So for Krugman, ‘while rising inequality wasn’t the main direct cause of the crisis, it created a political environment in which it was impossible to notice or act on the warning signs’.

Krugman also blames neoliberal ideology for America’s failure to counteract the impact of the crisis. In his view, the solution is to have a sufficiently large stimulus to bolster demand and get the economy moving again. For Krugman, free marketeers are, selfishly and irrationally, opposed to such measures.

Joseph Stiglitz, another Nobel prize winner, provides a variation on Krugman’s themes. Stiglitz was responsible for raising the concept of ‘the one per cent’ as dominating the rest of society in an article in Vanity Fair in May 2011. His most recent book, The Price of Inequality is probably the single most influential book on the subject.

In Stiglitz’s telling, there is a damaging interaction between three factors: excessive inequality, failures of the political system and economic instability. Combined together, these factors have led to America’s current plight.

Stiglitz, too, puts a heavy emphasis on the dangers of rent-seeking. He accepts that the normal operation of market forces leads to a degree of inequality but political manipulation can take it much further: ‘Much of the inequality that exists today is a result of government policy, both what the government does and what it does not do. Government has the power to move money from the top to the bottom and the middle, or vice versa.’

For Stiglitz, as for many other commentators, the solution lies at several different levels. ‘Addressing inequality is of necessity multifaceted – we have to rein in excesses at the top, strengthen the middle, and help those at the bottom.’

Stiglitz is less keen on the rhetoric of progressivism than some other commentators but his conclusions are similar. Curbing the power of the super-rich, including their ability to manipulate the political process, must be a priority. He supports measures such as tighter regulation of the financial sector, stronger competition laws and stricter corporate governance.

In essence, the new progressives are not advocating equality; they are not socialists of any form. Nor are they concerned with raising popular living standards. Their progressivist rhetoric is meant to convey a new nationalism, a Rooseveltian ‘true conservatism’, that emphasises the need to rein in excessive inequality. In so doing, they hope to promote state intervention at a time when it lacks legitimacy or public enthusiasm.

Conclusion: overlooking production

It is striking that all the different versions of the inequality argument have a common blind spot. They all focus on the problem of a lack of economic demand while downplaying the weaknesses of the supply side. In other words, their explanation leads heavily on insufficient consumption, while they are virtually blind to the problems of production.

This weakness is most clear in relation to those who directly blame insufficient demand for economic atrophy. Their arguments are reminiscent of someone who keeps on taking painkillers for a persistent headache. It may make sense in the short term, but it is probably not wise if the problem persists. Certainly, over a period of years, anyone suffering from regular headaches is best advised to seek medical advice to divine the underlying cause of the problem.

Similarly with economics, the time-horizon of the discussion is typically too short. It may be the case that consumers are nervous about buying goods in the midst of an economic downturn, but that does not explain why the economy has got into such a mess.

To understand what is going on it is best to look back at least as far as the 1980s. During that time the American authorities consistently kept public spending high, with interest rates often low, as a way of shoring up economic activity.

This approach has worked in the short-term but at the cost of storing up further problems for the future. The reason this crisis is so severe is precisely that underlying weaknesses of the productive side of the economy were not tackled at an earlier stage. Instead the authorities opted for inflating more financial bubbles that were bound to burst sooner or later.

Indirect theories of the financial crisis still tend to retain the assumption of a demand gap. Krugman, for instance, insists that solving the economic crisis is simply a matter of having a sufficiently large stimulus. For him the problem is cyclical. Once demand is restored, the economic cycle will regain momentum and, at that point, it will be necessary to impose austerity.

Krugman’s approach ignores the extent to which the crisis is chronic rather than cyclical. This is not to suggest that nothing can be done; only that it is necessary to tackle productive weaknesses rather than simply boosting consumption.

The political problems the critics of inequality identify should be seen as a symptom rather than a cause of economic weaknesses. It is clearly true that the financial sector has become extremely bloated since the 1980s. It is also the case that non-financial corporations have become increasingly concerned with financial activity. But these trends should not be seen as the result of simple avarice.

If the incomes of the top one per cent are more closely examined, they give some indication of what is happening. As Emmanuel Saez has pointed out, the incomes of the wealthy are closely tied to share options and realised capital gains (‘Striking it richer: the evolution of top incomes in the United States’). It is also true that a high proportion of the best-paid come from within the financial sector itself.

The burgeoning of the financial sector, and financial activity more generally, can itself be seen as the flip side of the weakness of the real economy. It is often more profitable for companies to manipulate finance than to engage in the real world of production.

In a sense, Krugman is right to argue there is common causation between economic crisis and widening inequality. It is true that both have the same roots, but it is wrong to argue that one has caused the other.

But the link between the two is not the neoliberal consensus blamed by Krugman. Instead, it lies in a chronically weak economy that has often succeeded in generating large financial profits, but has struggled to meet the needs of most people.

Greater regulation cannot provide a solution to this problem. The challenge is to restructure the real economy so that it can provide growth and raise popular living standards.